Month: February 2017

Articles

For a new trend, FIRE (Financially Independent, Retiring Early) is a great way of enjoying your life, if you are a young, upwardly mobile professional. I really like the concept of frugal living and then doing what you enjoy later in life.

Chapter 5: The Most Important Thing is.. Understanding Risk

Because none of us can know the future with certainty, risk is inescapable.

You’re unlikely to succeed for long if you haven’t dealt explicitly with risk. The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.

Risk is a bad thing, and most level-headed people want to avoid or minimize it.

An investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk.

When you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks.

Going beyond determining whether he or she can bear the absolute amount of risk that is attendant, the investor’s second job is to determine whether the return on a given investment justifies taking the risk.

When you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well.

If riskier investments reliably produced higher returns, they wouldn’t be riskier!

Riskier investments involve greater uncertainty regarding the outcome, as well as the increased likelihood of some painful ones. Riskier investments are those for which the outcome is less certain.

Many econnomists thing that risk equals volatility, because volatility indicates the unreliability of an investment. Marks’ takes great issue with this definition of risk.

It’s hard to believe volatility is the risk investors factor in when setting prices and prospective returns. People decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return.

The possibility of permanent loss is the risk Marks worries about, Oaktree worries about and every practical investor he know worries about.

But there are many other kinds of risk, and you should be conscious of them, because they can either (a) affect you or (b) affect others and thus present you with opportunities for profit. These include:

Falling short of one’s goal: Investors have differing needs, and for each investor the failure to meet those needs poses a risk. A given investment may be risky in this regard for some people but riskless for others. Thus this cannot be the risk for which “the market” demands compensation in the form of higher prospective returns.

Underperformance: Since many of the best investors stick most strongly to their approach—and since no approach will work all the time—the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up.

Career risk: This is the extreme form of underperformance risk: the risk that arises when the people who manage money and the people whose money it is are different people. Risk that could jeopardize return to an agent’s firing point is rarely worth taking.

Unconventionality: The possibility that unconventional actions will prove unsuccessful and get them fired. … Concern over this risk keeps many people from superior results, but it also creates opportunities in unorthodox investments for those who dare to be different.

Illiquidity: for this investor, risk isn’t just losing money or volatility, or any of the above. It’s being unable when needed to turn an investment into cash at a reasonable price. This, too, is a personal risk.

What gives rise to the risk of loss?

Risk of loss does not necessarily stem from weak fundamentals.

Risk can be present even without weakness in the macroenvironment. Mostly it comes down to psychology that’s too positive and thus prices that are too high. Fundamentals don’t have to deteriorate in order for losses to occur; a downgrading of investor opinion will suffice. High prices often collapse of their own weight.

The fact that an investment is susceptible to a particularly serious risk that will occur infrequently if at all—what I call the improbable disaster—means it can seem safer than it really is.

The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable. If the risk of loss can’t be measured, quantified or even observed—and if it’s consigned to subjectivity—how can it be dealt with? Skillful investors can get a sense for the risk present in a given situation. They make that judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value.

Because of its latent, nonquantitative and subjective nature, the risk of an investment—defined as the likelihood of loss—can’t be measured in retrospect any more than it can a priori.

The fact that something—in this case, loss—happened doesn’t mean it was bound to happen, and the fact that something didn’t happen doesn’t mean it was unlikely.

Taleb talks about the “alternative histories” that could have unfolded but didn’t. How often in the investing business are people right for the wrong reason? These are the people Nassim Nicholas Taleb calls “lucky idiots,” and in the short run it’s certainly hard to tell them from skilled investors.

With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)?

We can’t know which of the possibilities will occur, and this uncertainty contributes to the challenge of investing. “Single-scenario” investors ignore this fact, oversimplify the task, and need fortuitous outcomes to produce good results.

While clearly it’s impossible to “know” anything about the future. If we’re farsighted we can have an idea of the range of future outcomes and their relative likelihood of occurring—that is, we can fashion a rough probability distribution. We must think about the full range, not just the ones that are most likely to materialize. Some of the greatest losses arise when investors ignore the improbable possibilities.

One thing to keep in mind is that the correlation of these improbable occurrences can affect many of your investments at the same time.

We have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world. Quantification often lends excessive authority to statements that should be taken with a grain of salt. That creates significant potential for trouble.

Here’s the key to understanding risk: it’s largely a matter of opinion. It’s hard to be definitive about risk, even after the fact.

Investment performance is what happens when a set of developments—geopolitical, macro-economic, company-level, technical and psychological—collide with an extant portfolio. Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck. Return alone—and especially return over short periods of time—says very little about the quality of investment decisions.Return has to be evaluated relative to the amount of risk taken to achieve it.

Return alone—and especially return over short periods of time—says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured.

Investment risk is largely invisible before the fact—except perhaps to people with unusual insight—and even after an investment has been exited. Risk exists only in the future, and it’s impossible to know for sure what the future holds.

Decisions whether or not to bear risk are made in contemplation of normal patterns recurring, However, occasionally, the improbable does occur.

People usually expect the future to be like the past and underestimate the potential for change.

We hear a lot about “worst-case” projections, but they often turn out not to be negative enough.

Risk shows up lumpily.

People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation.

Finally and importantly, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.

Chapter 6: The Most Important Thing is…. Recognizing Risk

Great investing requires both generating returns and controlling risk.

High risk, comes primarily with high prices

Whether it be an individual security or other asset that is overrated and thus overpriced, or an entire market that’s been borne aloft by bullish sentiment and thus is sky-high, participating when prices are high rather than shying away is the main source of risk.

The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. High price both increases risk and lowers returns.

Risk arises when markets go so high that prices imply losses rather than the potential rewards they should. Dealing with this risk starts with recognizing it.

When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so … and risk compensation will disappear. So a prime element in risk creation is a belief that risk is low, perhaps even gone altogether.

“There are few things as risky as the widespread belief that there’s no risk.”

Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.

The degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions. Regardless of what’s designed into market structures, risk will be low only if investors behave prudently.

When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return.

The market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more risk that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. Marks’ calls this the “perversity of risk.”

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.

This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.

Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.

Chapter 7: The Most Important Thing is….Controlling Risk

When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.

Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard.

Great investors are those who take risks that are less than commensurate with the returns they earn.

Loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. The fact that the environment wasn’t negative doesn’t mean risk control wasn’t desirable, even though—as things turned out—it wasn’t needed at that time.

Risk control is invisible in good times but still essential, since good times can so easily turn into bad times. It’s an outstanding accomplishment to achieve the same return as the risk bearers and do so with less risk. Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.

Risky assets can make for good investments if they’re cheap enough. The essential element is knowing when that’s the case. That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.

Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so.

Important distinction between risk control and risk avoidance. Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.

Don’t run from risk. Welcome it at the right time, in the right instances, and at the right price.

It’s by bearing risk when we’re well paid to do so—and especially by taking risks toward which others are averse in the extreme—that we strive to add value

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.

I think Marks’ book is one of the nicest books on investment on the stock markets. More than a book, it is a compilation of a series of letters written by Howard Marks to the investors who invested with his firm, Oaktree Capital. In the particular Kindle Edition I read, there are also a comments on few of his important thoughts by other influential investors. I really got started on thinking off about investment in 2013 after I read this book, and it is only appropriate that this book should be one of the books I start of by reviewing. It is not so a much a review, as a collection of the highlights I did when I read the book. Read the highlights, but better still, read the book. It will open your minds in new ways.

Chapter 1: The Most Important thing is ….. Second Level Thinking

Few people have what it takes to be great investors. Some can be taught, but not everyone … and those who can be taught can’t be taught everything.

Even the best investors don’t get it right every time.

It is essential that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.

definition of successful investing: doing better than the market and other investors. To accomplish that, you need either good luck or superior insight.Counting on luck isn’t much of a plan, so you’d better concentrate on insight.

As with any other art form, some people just understand investing better than others. Only a few investors will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results.

being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others … which by definition means your thinking has to be different.

A second level thinker takes a great many things into account: What is the range of likely future outcomes? • Which outcome do I think will occur? • What’s the probability I’m right? • What does the consensus think? • How does my expectation differ from the consensus? • How does the current price for the asset comport with the consensus view of the future, and with mine? • Is the consensus psychology that’s incorporated in the price too bullish or bearish? • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.

The problem with investing is that extraordinary performance comes only from correct nonconsensus forecasts, but nonconsensus forecasts are hard to make, hard to make correctly and hard to act on.

to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.

Chapter 2: The Most Important Thing is…. Understanding Market Efficiency (and its Limitations)

The efficient market hypothesis states that •

There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed. •

Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.

• Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong. •

Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk. That’s a more or less official summary of the highlights.

Now Marks’ take. When he speaks of this theory, he also uses the word efficient, but he means it in the sense of “speedy, quick to incorporate information,” not “right.”

Because investors work hard to evaluate every new piece of information, asset prices immediately. reflect the consensus view of the information’s significance. Marks’ does not, however, believe the consensus view is necessarily correct.

If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or nonconsensus, view.

describing a market as inefficient is a high-flown way of saying the market is prone to mistakes that can be taken advantage of.

A market characterized by mistakes and mispricings can be beaten by people with rare insight.

Because assets are often valued at other-than-fair prices, an asset class can deliver a risk-adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes.

If prices can be very wrong, that means it’s possible to find bargains or overpay.

Marks’ wholeheartedly appreciates the opportunities that inefficiency can provide, but he also respects the concept of market efficiency, and he believes strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.

Efficiency is not so universal that we should give up on superior performance. However, we should assume that efficiency will impede our achievement unless we have good reason to believe it won’t in the present case.

For investors to get an edge, there have to be inefficiencies in the underlying process—imperfections, mispricings—to take advantage of. Some assets have to priced too low, or some too high. You still have to be more insightful than others in order to regularly buy more of the former than the latter.

Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.

The key turning point in Marks’ investment management career came when he concluded that because the notion of market efficiency has relevance, he should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.

We can fool ourselves into thinking it’s possible to know more than everyone else and to regularly beat heavily populated markets. But equally, swallowing theory whole can make us give up on finding bargains, turn the process over to a computer and miss out on the contribution skillful individuals can make.

Chapter 3: The Most Important thing is…. Value

The oldest rule in investing is also the simplest: “Buy low; sell high.”

There has to be some objective standard for “high” and “low,” and most usefully that standard is the asset’s intrinsic value.

For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point.

There are two general broad ways of investing (excluding technical analysis, which Marks dismisses with disdain).

The difference between the two principal schools of investing can be boiled down to this:

• Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.

• Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation.

To Marks, the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.

Compared to value investing, growth investing centers around trying for big winners. If big winners weren’t in the offing, why put up with the uncertainty entailed in guessing at the future? the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent. Marks describes himself as someone from the Value Investing School.

Is Value Investing Easy? No. For one thing, it depends on an accurate estimate of value. Also, If you’ve settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. That’s because in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away. The most value investors can hope for is to be right about an asset’s value and buy when it’s available for less. But doing so today certainly doesn’t mean you’re going to start making money tomorrow.A firmly held view on value can help you cope with this disconnect.

Many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy. An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.

Chapter 4: The Most Important Thing Is….The Relationship Between Price and Value

Investment success doesn’t come from “buying good things,” but rather from “buying things well.”

If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.

Remembering that the market eventually gets it right, is one of the most important things to remember when the market acts emotionally over the short term.

It’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times. This requires both long-term capital and strong psychological resources.

What should a prospective buyer be looking at to be sure the price is right? Underlying fundamental value, of course, but most of the time a security’s price will be affected at least as much—and its short-term fluctuations determined primarily—by two other factors: psychology and technicals.

Technicals are nonfundamental factors—that is, things unrelated to value—that affect the supply and demand for securities.

The second factor that exerts such a powerful influence on price: psychology.

Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship—and the outlook for it—lies largely in insight into other investors’ minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.

The key is who likes the investment now and who doesn’t. Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future. Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.

The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.

Psychology is an area that is (a) of critical importance and (b) extremely hard to master. First, psychology is elusive. And second, the psychological factors that weigh on other investors’ minds and influence their actions will weigh on yours as well.

It’s essential to understand that fundamental value will be only one of the factors determining a security’s price on the day you buy it. Try to have psychology and technicals on your side as well.

All bubbles start with some nugget of truth. A few clever investors figure out (or perhaps even foresee) these truths, invest in the asset, and begin to show profits. Then others catch on to the idea—or just notice that people are making money—and they buy as well, lifting the asset’s price. But as the price rises further and investors become more inflamed by the possibility of easy money, they think less and less about whether the price is fair. People should like something less when its price rises, but in investing they often like it more.

Valuation eventually comes into play, and those who are holding the bag when it does have to face the music. • The positives behind stocks can be genuine and still produce losses if you overpay for them. • Those positives—and the massive profits that seemingly everyone else is enjoying—can eventually cause those who have resisted participating to capitulate and buy. • A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments.

“Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time … or become far more so. • Eventually, though, valuation has to matter.

In bubbles, infatuation with market momentum takes over from any notion of value and fair price, and greed (plus the pain of standing by as others make seemingly easy money) neutralizes any prudence that might otherwise hold sway.

Buying at the right price is the hard part of the exercise. Once done correctly, time and other market participants take care of the rest.

One of the most important roles of your strong view of intrinsic value is as a foundation for conviction: to help you hang in until the market comes to agree with you and prices the asset where it should.

There are four possible routes to investment profit

Benefiting from a rise in the asset’s intrinsic value.

Applying leverage.

Selling for more than your asset’s worth.

Buying something for less than its value.

The most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly, value exerts a magnetic pull on price.

Of all the possible routes to investment profit, buying cheap is clearly the most reliable. Even that, however, isn’t sure to work. You can be wrong about the current value. Or events can come along that reduce value. Or deterioration in attitudes or markets can make something sell even further below its value. Or the convergence of price and intrinsic value can take more time than you have;

Trying to buy below value isn’t infallible, but it’s the best chance we have.

While much of the discussion here is on financial markets, my personal investments are more diversified. More than 50% of my investments are in real estate (including my self occupied house and office*). My equity investments (including PMS, Equity Mutual Funds and Direct Equity) amount to less than 25% of my total investment. Trading Equity(**) amounts to less than 7% of my entire set of investments.

Over time, I expect to see movement in this portfolio composition, with the relative allocation to equity increasing, the allocation to indian real estate investments decreasing, the role of overseas real estate investment increasing (from zero presently), the allocation to angel investments increasing and the role of bullion rising to around 2% of porfolio.

Notes

P.S. * I debated whether to include my self occupied house and office in my total investments. The reason for the debate is that you are unlikely to sell your house or office, so why include them in the mix. I eventually included them, because both are really too large for my long term needs. They are fungible, because I could also move to smaller spaces at a much lower cost.

P.P.S. ** While the amount of trading equity is only 6.7%, in reality, it is larger, if I include the cash I hold in reserve for drawdowns, and the stocks that I can give as margin for trading.

However, it is now time to revisit those reasons. The first reason I gave was a practical one. I was spending too much time on monitoring day to day performace, and that was taking a toll on me. Well, I have now used Access and VBA to create a database infrastructure, and so the difficulty in monitoring has been minimized greatly. I still have to spend half an hour or so everyday to enter everything, but I need it do monitor my trading activities anyway.

The second reason I gave was that I was spending too much time on minute by minute monitoring of my stock portfolio, leading to increased trading activity. Well, over time, I have acquired the discipline required not to obsess over minute by minute changes, even if I do monitor them. So I am less worried about it than earlier.

The third reason I gave was that as a long term investor, I did not see the need to compare myself with benchmarks on a monthly basis. I still believe this to be true. But I am now also a trader, and in trading, I am trying to trade for income. So that certainly involves monitoring myself in the long term and short term against benchmarks. Also, I realize that as an investor or as a trader, I do need to have “Alpha”, an outperformance against benchmarks.

Conclusion

Because my thinking has evolved, or because my situation has changed, I am now resuming the posting of monthly updates on performance.

Articles on wealth creation

What is the difference between Getting Rich and Staying Rich. The link has a great article on staying humble to stay Rich. I would also add that remaining teachable is also a good way to staying rich. It is hubris that can make the difference between Getting Rich and Staying Rich.

The wealth creation journey is not a slow and steady one. If one wishes high returns, one must be prepared for high drawdowns as well. The drawdowns are both in terms of money and in terms of emotions. Here is a great article which talks about the importance of stoicism in the wake of large drawdowns, and why reacting with equanimity to a large drawdown is critical if one wants monster returns.

Here is an extraordinary article on how to rationally evaluate the different returns that different asset classes obtain, and how to diversify away risk and volatility by constructing a portfolio. The conclusions are not great for someone seeking Alpha, as the author suggests that because diversification is extremely easy these days, and because there is a long history of markets, stock market valuations would rise to a point where the differential in return between stocks as an asset class and other asset classes like government bonds will narrow or disappear.

Here is a great post on different levels of investors, and how one can progress (if at all) from being a good investor to being a great investor, and from being a great investor to being a legend.

Here is a comparision of my last 2 month performace of both Trading and Investing, relative to various indices and mutual fund performance.

Investing performance is slightly understated, since it does not include dividends. In the next installment, I shall take care of this.

I have explained the methodology involved in creation of these performance curves elsewhere.

I don’t want to comment on this performance too much, since it is only a 2 month performance, during which the market yo-yoed like crazy. But still, it is interesting to note that my investing performance was better than my trading performance.